One problem with commercial loan portfolio due diligence is that there is no common underwriting standard between community banks. Mortgages, autos, consumer and other retail-type of loans tend to be more standardized since liquidity is greater. However, when it comes to commercial lending, the difference between banks can be wide. One bank’s “3” rated credit can be another bank’s “6.” While this is understandable between banks, this credit gap can even be found within one bank as different regions, branches and even lenders can propagate these systemic differences. This credit discrepancy means greater underwriting costs, translation problems when determining a portfolio’s value, incompatible enterprise risk management measures, more processing issues and less liquidity. As banks strive for more loan production, greater efficiency and better risk management, inconsistent commercial loan underwriting is a major impediment.
A Common Standard
The problem is that most banks have always lived with this friction and thus do not recognize this as a problem. In days of yore, most lenders and underwriters were classically trained by one of the large banks in a rigorous training program. As a result, there were just a handful of systems – Bank of America, Fleet, Citibank, etc. These systems helped my loans more homogenous between institutions. There was also less liquidity in terms of M&A, portfolio and loan sales. Now less training, more migration of bankers between banks, more global banking influences and greater loan liquidity all result in the fact that it is more valuable than ever to have common underwriting translation. In a perfect world, one bank’s “3” rated credit would equate to a certain probability of default which would be the same for another bank’s “3” rated credit.
To solve this problem, one common method that large banks use is to adopt the single asset / single borrower Moody’s (updated) and S&P underwriting standards used for public markets. This has the most academic and practical rigor since many of these loans can be observed in the marketplace and prices can be translated into a proxy for credit risk. Because of this quantifiable credit risk, the commercial loan market has been the focus of a deep stack of academic research. As such, in 2015, we have a much better understanding of quantified credit risk than we have ever had in the history of banking. By using these standards, banks can translate that their “3” rated credit equates to an equivalent of a “BBB” rated credit.
To keep things simple, we are just going to discuss the translation into a one-dimensional model which is a ratings scale that combines both the probability of default and loss given default. This isn’t ideal, but it is most common among community banks and has the advantage of being simple and approximately correct. In the future, for those banks that are interested, we will discuss how banks apply the below construct to a two or more dimensional model.
To translate, banks can look up a property’s market-loan-to-value (MLTV), apply the adjustment factor discussed below and then see the appropriate rating on the right side. What the system lacks in accuracy, it makes up in simplicity and homogeneity. To be applied, analysts only need to update the last appraisal to market value, make the adjustments and then come out with an approximate rating.
To further refine the above table, the public markets often make broad adjustment for some key credit factors. For example, if the financed asset is composed of multiple cash flowing properties with cross-collateralization, then the MTLV is adjusted downward by 25%. In similar fashion, if the loan has recourse and strong global cash flows, is in a major market, is a trophy-type property or has historically very stable cash flows then they get the below-indicated adjustment. Conversely, if it is a floating rate loan, has a balloon structure, has volatile cash flows, weak covenants, or is a special use property, then it would get a negative adjustment.
Thus, if you have a fixed rate loan with a recent appraisal at 75% LTV, with recourse and strong global cash flows (2x), then you can deduct 20% and come up with an adjusted MLTV of 55%, or the equivalent of an “A3” rated credit (you go to the next highest MLTV level). This would be equivalent of an approximate 2% probability of default or credit mark.
Banks can also look up the level of protection from the second column from the left and see what percentage the collateral’s market value would have to decline before the loan is impacted. For comparison, most commercial properties dropped 40% from peak-to-trough during the last recession.
This methodology isn’t foolproof, but it is a good guide to help credit managers understand the value and risk level of their portfolio. The public markets have given us a tremendous set of data, a data set that has largely been validated by the community bank experience from 2008 to 2010. Use this quick method to easily benchmark your loans (or another bank’s loans) and the experience will help you be more consistent with your own, internal underwriting.
Submitted by Chris Nichols on August 20, 2015